Rob Cox: Crazy valuations not only sign of bubble

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By Rob CoxThe author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Crazy valuations – even after a recent dip – are not the only signal that parts of the U.S. stock market, particularly internet companies, are in bubble territory. The willingness of investors in hot initial public offerings to accept second-class stock and governance that favors insiders suggests an imbalance between providers of capital and its consumers. Add head-scratching market caps based on contorted metrics, and this risks storing up trouble when the inevitable headwinds arrive.

The best description of the stock being hawked in this way is “coattails equity.” It offers little beyond a chance to tag along with entrepreneurs from Wall Street, Silicon Valley and China. Buyers of shares in IPOs such as those of Box, GrubHub, Moelis & Co, Virtu Financial and Weibo – and probably $100 billion-plus giant Alibaba – must give up rights that have traditionally accompanied the ownership of common shares, like a representative voice in corporate decisions.

It’s a big shift in the paradigm of stock ownership, and it could make the next downturn trickier in some ways even than the tech collapse at the turn of the millennium. The most obvious governance problem is a multiplicity of classes of shares. Weibo, the Twitter-like service of Chinese internet conglomerate Sina, is selling Class A shares in New York. These take a back seat to the B shares that Sina will continue to own and which carry triple the votes.

That’s nothing compared to Box, the company Aaron Levie founded in his dorm room. Box sells a service with not very obvious barriers to entry that allows customers to store their digital files on the internet. Box’s Class A shares have just one-tenth of the votes that attach to its Class B shares, which should allow Levie and his backers to call the shots long after their economic interests shrink.

Such structures are not uncommon in tech land. Google just last week created a third class of shares to further consolidate the control of its founders. And Facebook went public in 2012 with two classes that entrench the influence of founder Mark Zuckerberg. But the idea seems to be migrating further and further from Greater San Francisco. Two savvy practitioners of the dark arts of finance are taking the practice to new lows.

Ken Moelis’ eponymous investment bank sports two classes of stock, with the B shares carrying a supersized 10 votes each. Even more noteworthy, these super-voters will be collected in an entity which will be 97 percent controlled by the founder. Thanks to the control arrangements, the listed company won’t need to ensure a majority of the board is independent, nor does it have to put independent directors on its compensation and governance committees.

Virtu Financial’s IPO takes it up another notch with four classes of stock. As a result of the recent brouhaha over high-frequency trading sparked by Michael Lewis’s book “Flash Boys,” the offering has been delayed, according to news reports. When it does come, though, founder Vincent Viola’s holdings of Class D shares, with 10 times the votes of new investors’ stock, will allow him to wield control.

According to the prospectus, that includes “the election of our board of directors, the adoption of amendments to our certificate of incorporation and by-laws and the approval of any merger or sale of substantially all of our assets.” All this complexity in corporate structure comes despite Virtu’s auditors finding “a material weakness in our internal controls over financial reporting” for 2013.

Lousy governance is not, however, confined to companies with dual or even quadruple stock structures. Take GrubHub, the restaurant delivery service website whose share price popped 31 percent on its first day of trading last week. The company’s certificate of incorporation includes a litany of by-laws designed to insulate executives against pesky shareholders, including a poison pill to repel any unwanted takeover, limits on the abilities of stockholders to call special meetings, and an old-school staggered board of directors.

The structure means shareholders only get to elect a third of directors every year, which impedes the ability of unhappy investors to wage a proxy fight to overhaul a poorly performing board. Last year, just 11 percent of companies in the S&P 500 Index had this kind of arrangement, down from more than 52 percent in 2005, according to law firm Fried Frank.

In effect, GrubHub and its ilk are taking investors back in time, winding back rights that activists and shareholder advocates have worked for decades to establish. In many cases the businesses concerned are innovative and disruptive. But when it comes to shareholder democracy, they’re retrograde.

For now, investors don’t seem to mind. They’re hungry for growth, and that’s what Box, Weibo, Moelis and others offer. But when these businesses and their leaders mature or, God forbid, fail to capitalize on their founders’ visions, shareholders will regret there isn’t much they can do about it.

I would rather Googlers and other founders control tech companies than bean counters more interested in monetization than providing a quality product or service.

The moves by tech companies and other startups to limit the power of non-practicing investors, e.g not engineers, is ideal. Capital shouldn’t buy anything more than a return.

Investors don’t have the requisite knowledge to even begin to understand the software or hardware that a modern information company deals with. They have proven this in spades over the past 40 years. The push by the Ichans of the world for short term profit has hampered market innovation not ignited it.

Investors should be thankful that they are allowed to invest, its essentially free money at this point.

Author Profile

Rob Cox helped establish Breakingviews in 2000 in London. From 2004 he spearheaded the firm's expansion in the United States and edited its American edition, including the daily Breakingviews columns in the New York Times and Wall Street Journal. Rob has worked as a financial journalist in London, Milan, New York, Washington, Chicago and Tokyo. Rob graduated from Columbia University’s Journalism School and the University of Vermont. Follow Rob on Twitter @rob1cox